Why do we use and require a side letter to consider investing?
With recent years of experience, angel investors have faced a wide range of differences in deal structures and the forms of the agreements they are asked to sign. There are many different legal approaches, document templates, and opinions held by various attorneys used by startups across the country. Every legal template has deficiencies that can lead to souring the startup-investor relationship. Reviewing the number of documents in the package and their lengths can be time-consuming.
In theory, they should all be negotiated paragraph by paragraph. But, within the narrow windows of time that founders have to fill their rounds with many investors and all the diligence material that needs to be covered, legal documents are often marginalized. Yet, they are the final words that govern the relationship! This has often led to miss-set or missed investor and founder expectations post-investment. Startup teams and investors agree that they greatly desire a positive working relationship because startups cannot afford to add shareholder relationship problems to the many challenges they face to achieve a great exit.
We have crafted a short, simple agreement that pre-sets a few of the most important expectations up-front rather than putting everyone through a rigorous diligence review process only to find out that they cannot agree to these essential investor protections in the final stretch of document signatures and check writing.
What are the basic elements in the side letter and what do they accomplish?
Establish a minimum aggregate investment amount for an organized group or individual Investor(s)
We understand that it takes a worthwhile investment to justify a side agreement. However, the unregulated nature of angel networks makes it impossible to know how much their investors want to invest until after the pitch meetings and diligence are completed. So, the side letter sets a threshold of a minimum amount of investment that the group must be able to circle for the side letter provisions to be binding on the company. If the group fails to meet or exceed this minimum amount of investment, then the side letter is without effect and the company has no obligation to honor it.
Set reasonable triggers to release funds
It has become an unfortunate circumstance in many startups’ fundraising efforts to see their rounds remain open for long periods (beyond six months, a year, and even longer) while they are only able to raise small amounts at a time. “Rolling closes” are far too common. This sets up a condition where a startup must continuously cash any checks it can attract to keep the lights on and keep fundraising. But this has the effect of using those funds inefficiently. Rather than a significant amount of money being raised relatively quickly so that the fundraising effort can stop and all the funds received then devoted to achieving the company’s next milestones (themselves necessary to unlock future rounds of funding), slowly raised funds get absorbed maintaining payroll and fixed expenses.
In addition, many startups have trouble finding lead investors to negotiate and set the terms of the raise, and so end up self-leading the raise at terms they find hard to find investors to support. Lead investors are a very important and desirable feature of a raise because they bring a significant start to filling the round and then syndicate and promote the deal to other investors in their network. This kind of investor validation accelerates a startup’s ability to fill and close the round so it can focus on running the company and making progress.
We are willing to lead rounds and is also willing to quickly follow another lead investor and become the next investor. However, the first investors to invest in the course of a round are subject to the additional, uncompensated risk that the last investors in the round do not face – the risk of the company not being able to quickly fill its round. If the first investors see their checks cashed to keep the company alive and the company’s ability to attract more investors slows or stalls, those sunk funds are gone and those investors have no recourse. This is much more likely to occur in company-led rounds. A well-planned company able to execute fundraising has plenty of cushion in the bank before starting its next fundraising round. Companies already low on cash when starting a fund-raise have that much more difficulty gaining new investors because those investors will worry that the company will burn cash faster than it can raise it.
Therefore, the side letter requires that funds be escrowed until a certain amount of the raise from all investors in the round is achieved. This is an old, original practice that got lost over the years but was always a best practice – aiming for a common closing for all investor funds so that no single investor in the round is taking more risk than another at the same terms, simply because one investor wrote a check before the other.
Depending on circumstances, the side letter may also require releasing a portion of funds at closing and then withholding a portion to be released after the company achieves a future planned milestone with the funds already released. This keeps the company and its investors aligned around and focused on the company’s business plan. The investors are just as incentivized as the business is to work together so that those funds can be released and the business can continue growing in value to the marketplace. This provision tends to be used more often in large rounds intended to raise enough funds to achieve multiple, critical milestones with an extended time before the next raise. It might also be used as a better alternative to companies that already want to divide their raise into tranches because it raises the funds for all tranches up front and removes the risk of failing to receive enough investment interest for a subsequent planned tranche, allowing the company to focus on its milestones.
Reduce minimum investment amount per investor
Before the availability of so many inexpensive smart cap table management software solutions, startups in the early stages struggled to hire in-house, or retain sufficiently competent, CFOs to organize and manage shareholder information. Poorly kept cap tables in haphazardly designed spreadsheets were often referred to in the VC world as “dirty”. It mattered when a startup making progress and ready to scale approached VCs and strategic investors for later, larger rounds of fundraising only to encounter resistance because later investors felt that there were too many individual shareholders already to communicate with.
As a result, Special Purpose Vehicles (SPVs) in the form of LLCs to pool investor funds into a single line item on the startup’s cap table became prevalent. Then, these became startups’ and investors’ annual tax-reporting and administration nightmares. Today, many angel groups have dozens and even hundreds of these entities in existence, chronically expensive to manage and always up against pressures to produce K-1s so that investors can file their tax returns under the wire late each year. It has become untenable and now threatens to be a barrier to the next generation of investors to adopt the angel investing activity. As it is, GenX is 1/3 smaller than Boomers. Startups cannot afford unforced barriers to entry to making investor capital available.
Therefore, we advocate that any startup today should be using smart cap table management software and simple digital communication methods that make it easy to manage shareholder relations no matter how many shareholders are on the cap table. The utilization of SPVs is unsustainable and must be minimized. The multiple attempts that have been made to build companies around SPV management have not solved the problem, they only add a management layer that needs to be paid to an already high-cost activity. Tthe famous sudden bankruptcy of Assure looms as an additional crisis that can happen at any time with any of these SPV companies trying to find an affordable fee schedule to charge able buy the expertise of lawyers and accountants that do not come cheap.
With the use of smart software and our strict adherence to investing only in C-Corporations, the annual K-1 hassle is resolved. As such, the side letter establishes a lower investment minimum for individual investors associated with our organization to invest in your company’s round, and this further benefits you by attracting more net dollars of investment because it opens the round up to smaller checkwriters who are more numerous and aggregate together to add more dollars to the company.
Keep investors engaged and motivated to make follow on investment
Most angel investors will want to reward companies making promised progress, and re-invest in future rounds to maintain their equity in the company and enhance their returns. One of the most (in our opinion, predatory) practices that have arisen is later-series investors attempting to recapitalize a company and push out the prior investors, without whom a company would not have reached the point it has. Sometimes when a company is struggling, its attorneys design rounds aimed at threatening prior investors to reinvest to keep a company alive (and its bills paid) or else be converted to common equity at a ridiculous conversion ratio meant to wipe early investors out. These egregious practices are never anyone’s intention at the start, but down the road, when they happen, it is destructive to the entire ecosystem. If seed investors get treated this way much more, they simply won’t be interested in being seed investors and it will leave a gap in capital availability that will crush startups before they can build to a place that larger checkwriters are willing to underwrite.
It is always far better for a company to build a relationship of mutual trust with all its investors and achieve its business goals so that its investors are already incentivized to keep investing – and they will want to. To ensure we get started on the “right foot”, the side letter ensures that it will never be threatened with a “cram down” and, as such, sets up a trust relationship where investors in the current round will desire to invest in future ones without being forced to. The side letter asks to continuously preserve the right for existing investors to re-invest, which will keep them engaged and interested in following the company’s progress.
Preserve information rights
Continuing to support principles already laid out above that keep investors and the startups they invest in aligned and supporting one another, the side letter standardizes certain common (but not always coincident) information rights for all investments its investors make. These include quarterly reports, an annual 409A valuation, inspection rights to monitor the financial health of the company, and a board observer seat to monitor company strategic decisions, assisting with advice where asked. The board observer also serves the company as a single point of contact so that the other associated investors have someone to discuss company progress with, without distracting company management.
Is it difficult to review or execute the side letter? I don’t have a lot of time.
We have crafted its side letter to use simple language, be brief and to the point, and streamline viewing, signing, and saving online. Links as needed will be provided via email and documentation stored in our deal flow management deal room.
What if, after signing the side letter, my round is filled and closes before we decide to invest? Or, what if I later change my mind?
Bear in mind that the letter simply doesn’t matter unless two things occur: 1) we offer to invest at least the minimum amount outlined in the letter and 2) the company accepts the investment. At any time before investment, you may withdraw your application from consideration or even (and we hope this doesn’t happen) complete the diligence process with us but then decide not to accept our investors. The side letter does not take effect until our investors write their checks in sufficient amounts, so there is absolutely no risk to the company from signing the letter now as a pre-requisite for the opportunity to continue in the screening process with all associated or prospective investors.